Consider the following information on Huntington Power Co.
Debt: 4,000, 7% semiannual coupon bonds outstanding, $1,000 parvalue, 18 years to maturity, selling for 102 percent of par; thebonds make semiannual payments.
Preferred Stock: 10,000 outstanding with par value of $100 and amarket value of 105 and $10 annual dividend.
Common Stock: 84,000 shares outstanding, selling for $56 pershare, the beta is 2.08
The market risk premium is 5.5%, the risk free rate is 3.5% andHuntington’s tax rate is 32%.
Huntington Power Co. is evaluating two mutually exclusiveproject that is somewhat riskier than the usual project the firmundertakes; management uses the subjective approach and decided toapply an adjustment factor of +2.1% to the cost of capital for bothprojects.
Project A is a five-year project that requires an initial fixedasset investment of $2.4 million. The fixed asset falls into thefive-year MACRS class. The project is estimated to generate$2,050,000 in annual sales, with costs of $950,000. The projectrequires an initial investment in net working capital of $285,000and the fixed asset will have a market value of $225,000 at the endof five years when the project is terminated.
Project B requires an initial fixed asset investment of $1.0million. The marketing department predicts that sales related tothe project will be $920,000 per year for the next five years,after which the market will cease to exist. The machine will bedepreciated down to zero over four-year using the straight-linemethod (depreciable life 4 years while economic life 5 years). Costof goods sold and operating expenses related to the project arepredicted to be 25 percent of sales. The project will also requirean addition to net working capital of $150,000 immediately. Theasset is expected to have a market value of $120,000 at the end offive years when the project is terminated.
Use the following rates for 5-year MACRS: 20%, 32%, 19.2%,11.52%, 11.52%, and 5.76%
Please show your work.
- Calculate project B’s cash flows for year 0-5
